Ferrari: Leverage and Return on Owners' Equity Flashcards
Critical measure of return from society’s point of view
Return on total assets; society is the ultimate winner/loser regardless of how resources were financed
Return on equity, Ferrari
Ferrari equation pieces
ROE (T/S) - investor
ROA (I/A) - society
ROS (U/P) - regulator
Insurance leverage (1 + R/S)
P/S - insurance exposure
Insurer leverage
Due to fact premiums are paid before they receive a return
“Second form” of Ferrari equation
U/R meaning in second Ferrari equation
Interest cost to insurer for using reserves
Using Ferrari’s equation to determine whether to keep writing business
If brackets are negative, don’t write business
Leverage ratio as indicator
Riskiness of owner’s investment in the firm
Two factors accepted as determinants of the value of a firm
Expected earning stream (increase)
Rate at which stream is discounted by market (decrease)
How writing more business changes firm value
- Increased earnings stream (increases value)
- Volatility increases -> increasing discount rate (decreases value)
Balcarek issues with Ferrari formulas
- Premium should not be expanded to infinity
- Formulas lend themselves best to static state
- Other relationships will not stay constant
According to Balcarek, 3 relationships ignored by Ferrari
Relationship between P/S and I/A
When P/S increases, I/A will decrease:
(a) Cash and agents’ balances will tend to rise
(b) Higher risk requires more conservative investment policy
Relationship between P/S and U/P
Will move in the same direction - insurer can safely write larger premium with same surplus if UW results are more favorable
Relationship between U/P and I/A
Tend to move in same direction - if UW results are good insurer can be more aggressive with investments
